Avoid the mistakes small investors make at market tops

Thomas H. Kee Jr. is the president and CEO of
Stock Traders Daily (dotcom), where he offers strategies and newsletters to
both institutional and individual investors, and he manages money privately for
both institutional and individual investors through Equity Logic LLC. A
specialist in technical analysis, Kee is also the founder of one of the leading,
longer-term fundamental economic and stock market indicators in history, The
Investment Rate. This proprietary tool, which is available to clients, too,
predicts major economic cycles well in advance, and has been accurate since
1900. Using his broader observations of the economy to define disciplines, Kee
has been able to accurately predict market cycles in advance using his
multi-tiered technical indicators, and that combination has kept him ahead of
the curve since starting Stock Traders Daily in January 2000.

I have been in this market since the middle of the 1990s, and whether it was the debacle that followed the Internet bubble, the bullish market conditions between 2002 and 2007, or the credit crisis, over all of these cycles one thing has been abundantly clear: When the market makes a longer-term top and then begins to turn, smaller investors play a significant role, and usually make significant mistakes.

About two-and-a-half weeks ago, I issued an important alert to clients identifying what seemed to be arrogance on the part of smaller investors. They seemed to be so overly confident that it was off putting, and immediately, we shorted the Russell 2000. That trade paid off and is paying off, and the catalyst for that decision is part of this discussion.

When smaller investors jumped in with both feet, like they have in recent months, it should be a red flag to everyone else because almost always smaller investors buy at the top and sell at the bottom.

Because we are nowhere near a market bottom at current levels, our discussion here is about the mistakes that smaller investors make when the market turns down from a longer-term top.

The first mistake is that they fail to differentiate the company from the stock price. A great historical example over time has been Apple
AAPL, +1.72%
because investors love the product and thought the stock would go up forever until it fell on its face last year. They fell in love with the stock because they liked the company, but those two things do not necessarily go hand in hand.

The better immediate example in today's market is Twitter
TWTR, -2.30%
I would argue that Twitter has an excellent product, they have excellent growth rates from a subscriber bases, but the company simply is not making any money, they are not even generating substantial revenue, and the stock price, from a valuation perspective, is out of this world. Still, smaller investors seemed to fall in love with the stock because they love the product.

When these mistakes are made after longer-term tops in the market are established, the result is often a substantial loss for investors that fail to manage their risk. Using Twitter as an example, after the company reported earnings, in the after-hours session, we sent an email alert because stock was trading at our stated resistance level. Since then, the stock has pulled back by 20%. It seems to be on its way back down again, toward our longer-term support level, and we are not in love with the stock as a result. Still, some smaller investors remain that way, to their detriment.

The second mistake smaller investors make after market tops is a rationale that they indeed will plan to go to cash after they get back to where they were before the declines began. Instead of just selling, they decide to wait for a bounce, and after market tops, bounces never come. This is the error that caused wealth destruction for so many in 2008.

A great example of this is General Electric
GE, -0.72%
I'm using a widely owned stock in this example because people tend to think that even large-cap, blue-chip companies will not fall if the market falls. They realize the quality of the company, and GE is a high-quality company in my opinion, and they determine that they could hold on to the stock no matter what happens to the market.

Surely, General Electric will probably survive any market setback. It has a history of doing that, and I do believe that the company can survive even the most aggressive of market pullbacks, but the stock price is a completely different story. Investors who allow their golden handcuffs to prevent them from selling when longer-term peaks in the market are established often find themselves significantly under water in companies that are otherwise considered to be high quality. Golden handcuffs cause investors to hold on even when the market is set up to fall on its face, and those decisions are often supported by large brokerage firms who get paid to keep you invested at all times (that's how they generate fees).

In the specific case of General Electric, the company has a PEG ratio well over 4, with a yearly earnings-per-share (EPS) growth rate of 3.87%. When the multiple is compared to the growth rate, the stock looks rich, valuations are extended, yet some investors surely will let those Golden Handcuffs influence their decision to hold or sell.

Smaller investors not only help us identify longer-term peaks in the market, they also make mistakes around those longer-term peaks that could end up being devastating to them. Based on my macroeconomic analysis and my evaluation of Net Real Stimulus (NRS), we may have seen a longer-term peak, and I am advising all investors who might fall prey to these mistakes to approach their decisions in a mechanical fashion, businesslike, and without emotion, because over the past 20 years, I have learned that those investors who get hit hardest are the ones who fail to approach the business of investing as a business.

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